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3 G L O B A L F I N A N C I A L M A R K E T S D E P A R T M E N T Securitisation in Russia WAYS TO EXPAND MARKETS AND REDUCE BORROWING COSTS Position Paper of the International Financial Corporation s Technical Working Group on Securitization March 2005

4 Copyright 2005 Global Financial Markets Department Securities Markets Unit Phone:

5 TABLE OF CONTENTS Table of Contents INTRODUCTION 1 SUMMARY 2 PART I: General Overview 5 What is securitisation? 5 Impact of securitisation on capital markets and other markets 5 Types of assets that can be securitised 6 Brief description of the classic true sale securitisation 6 Role of the rating agencies 7 Benefits of securitisation for its participants 7 The securitisation market in Europe and the United States 8 Potential benefits of securitisation for Russian capital markets 8 Securitisation laws adopted by European countries 9 PART II: Technical Aspects of Securitisation 10 Parties and their roles 10 Typical securitisation structures 11 Classic securitisation through true sale 11 Conduit vs. standalone transactions 13 Synthetic securitisation 13 "Whole business" securitisation 14 Typical elements of a structure 14 Role of the Rating Agencies 15 Impact of a new accord of the Basel Committee on Banking Supervision on capital adequacy (Basel II) 16 Accounting rules 17 Key requirements for a legal system to allow for securitisation transactions 18 Tax treatment of securitisation 19 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs I

6 TABLE OF CONTENTS PART III: Actions to be Taken 20 Existing Environment 20 Proposed Aspects of Reform 21 Receivables eligible for securitisation 21 True sale of receivables 23 The Purchaser (SPV) 25 Purchaser's bankruptcy remoteness 27 Credit enhancement, tranching and hedging 28 Ongoing servicing by the Originator; mitigation of commingling risk 31 Asset-Backed Securities 32 Data protection and banking secrecy 32 Currency regulation and control 34 Tax implications 35 Consumer Loans 37 ANNEX I: Summaries of European securitisation laws 38 ANNEX II: Actions to be Taken to Create a Favourable Environment for Securitisation Transactions in Russia 44 ANNEX III: Securitisation Glossary 49 ANNEX IV: List of members of the working group's "executive committee" 50 II Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

7 ACKNOWLEDGMENTS Acknowledgments This paper was prepared by members of the Securitization Technical Working Group in Russia, as part of an IFC-sponsored project to help improve Russia s legal and regulatory environment for and support development of a domestic securitization market. Key contributors were from the Vienna office of Freshfields Bruckhaus Deringer (Fredrich Jergitsch), which was the advisor to the Working Group, and the Moscow offices of Alfa Bank (Simon Vine), Baker & McKenzie (Vladimir Dragunov), Finamatics (Alexander Ivanchenko), PriceWaterhouseCoopers (Alex Bertolotti), Standard & Poors (Igor IassEnovets), and White & Case (Maya Melnikas). The Working Paper is published by IFC s Global Financial Markets Department, Securities Market Advisory led by Alison Harwood (project team leader). Aichin Jones provided graphics and layout. IFC s Moscow office also participated and supported the project. Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs III

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9 INTRODUCTION INTRODUCTION In spring 2003, the International Finance Corporation (IFC) established a working group (the Group) to discuss and examine whether the current legal environment in Russia would permit securitisation transactions, and which legal changes may be suggested to lawmakers to make the legal environment more favourable for securitisation transactions. The Group comprises local representatives of a number of leading international law firms and audit firms, one international rating agency, a number of Russian banks, and representatives of the Russian Duma, the Ministry of Economic Development, and the Central Bank of Russia. The Group discussed all aspects of securitisation, using (in particular) the securitisation of consumer loans as an example. The Group has prepared this Position Paper to present its findings to interested decision makers. Part I contains a general description of securitisation, and why it is important to Russia. Part II sets out in more detail the technical aspects of securitisation. Part III sets out proposed amendments to Russian law to facilitate securitisation transactions in the Russian Federation. In Annex 1, existing securitisation laws of France, Italy, Spain, Greece, Portugal and Poland are summarized. Annex 2 contains a chart summarising the Group's proposals on amending Russian law. Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 1

10 SUMMARY SUMMARY The development of the securitisation market over the last decades has had a significant effect on the world's capital markets. By introducing a new class of debt instruments, and allowing access to new participants to the market, it has expanded and deepened the world's capital market. The ability of Russian market participants to successfully effect securitisation transactions largely depends on whether Russian law allows them to implement a number of key concepts and use instruments and mechanisms which are typical of such transactions. There are three principal types of securitisation: true sale, synthetic and whole business. This Position Paper contains analysis of, and proposals to amend, only those legislative provisions that are applicable to classic true sale securitisation transactions. In essence, securitisation is the financing or re-financing of income-yielding assets (for example, receivables generated in the ordinary course of business) of a company by packaging them into a tradable, liquid form through the issue of bonds or other securities. The company (usually referred to as the Originator) transfers a pool of its assets to a special purpose entity, which in turn issues bonds secured by the transferred assets. On the world's capital markets many types of assets can be securitised, for example, loans and credit card receivables, trade receivables and even uncontracted future cash flows. While legislation should ensure that the maximum amount of asset types can be used for this purpose, in Russia the scope of receivables eligible for securitisation is much narrower compared to other jurisdictions. In order to expand the scope of receivables that can be securitised, it is necessary to provide additional mechanisms allowing the identification of certain types of assets to be transferred (for example, in relation to rights that are identifiable rather than rights which have already been identified, as well as future receivables). Legislation is to provide for mechanisms for effective transfer of assets within securitisation transactions. Any obstacles to a valid transfer such as pro- 2 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

11 SUMMARY hibitions of assignment of receivables, data protection or banking secrecy rules, the need to notify an obligor of the assignment in order for the assignment to be effective, the impossibility of transferring assets because of a contractual prohibition on transfer or the need to register the transfer reduce the scope of assets eligible for securitisation. Similarly, if assets cannot be transferred in a tax-neutral way, securitisation may become economically infeasible. In accordance with international practice any assets or entitlements of corporate entities and state authorities, representing future (predictable) cash flows, should be capable of being securitised to the extent that they can be effectively transferred to a special purpose vehicle through a true sale. The true sale is a key concept for effecting securitisation transactions. This concept implies that once the Originator has sold or otherwise transferred assets to the special purpose vehicle, the transfer cannot be challenged, voided or otherwise reversed in the insolvency of the Originator or in any other cases other than those provided for under the transaction documentation. In typical securitisation transactions, the Originator does not notify debtors of the transfer of assets and continues to service them (e.g., collect the receivables) on the same terms as before the securitisation, and transfers the relevant proceeds to the special purpose vehicle, which will make payments under the securities. It is worth noting that in such case there is a commingling risk, i.e. the risk that cash proceeds from the securitised receivables will become part of the Originator's bankruptcy estate in case of its bankruptcy. Legislation should provide for a mechanism to segregate the securitised assets from other assets of the Originator. A special purpose vehicle is typically incorporated as an insolvency remote entity with limited legal capacity. Bankruptcy remoteness implies that the special purpose vehicle's right to initiate its voluntary liquidation and reorganisation is restricted, while all parties to contracts with the vehicle agree that they will not petition for the winding-up or insolvency of the vehicle. In addition, the parties will acknowledge that the extent of any rights they may have is limited to the available assets of the special purpose vehicle. The concept of limited purpose, which is part of the concept of bankruptcy remoteness implies that by virtue of its corporate constitution (and/or legislative provisions), the special purpose vehicle may not issue any additional debt, enter into mergers or engage in any other transaction, including personnel hiring, other than those necessary to effect the securitisation. In order to finance the purchase of the assets, the SPV issues securities (whose performance is dependent on the performance of the assets) referred to as asset-backed securities because the purchased assets typically represent the principal source of cash to service the securities. Although current Russian legislation permits the issue of secured bonds, existing restrictions make such bonds an ineffective instrument. In addition, one of the key concepts that should be addressed by legislation on asset-backed securities is the concept of subordination arrangements and priority of payments under such securities. The concept of subordination arrangements and priority of payments implies that while servicing securities and/or in the case of bankruptcy proceedings the special purpose vehicle makes payments to holders of bonds and other relevant parties in strict sequence in accordance with the priority of payments agreed in the transaction documentation. Thus certain parties will be paid out in full before others. Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 3

12 SUMMARY As a rule, in order to obtain funding on better terms, the Originator will provide additional security, which is called in the securitisation context credit enhancement, and also uses other means to enhance the robustness of the securitisation structure, for example, mechanisms for liquidity enhancement and instruments for hedging financial risks. Current Russian law does not provide for the use of these arrangements. Parties to securitisation transactions should be able to enter into a wide range of agreements aimed at enhancing the robustness of securitisation structures and protecting investors. Ultimately, legislation should allow the effective use of pledges of funds, bank accounts, liquid securities and securitised assets, as well as insurance of risks relating to defaults of receivables, and expressly grant judicial protection to hedging contracts made in the context of securitisation. The main part of the Position Paper clarifies and analyses in detail the above concepts of true sale, bankruptcy remoteness and limited purpose of an entity, subordination arrangements and priority of payments, the mechanism for identifying, transferring and segregating assets, secured bonds, mechanisms of credit and liquidity enhancement and instruments of hedging financial risks both in the context of international practice and within the context of current Russian legislation. It also contains recommendations and comments on proposed amendments to Russian legislation to ensure use of such concepts, mechanisms and instruments by market participants in full to effect securitisation transactions. 4 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

13 PART I: GENERAL OVERVIEW PART I: General Overview WHAT IS SECURITISATION? There are many ways to describe securitisation but in essence, it is the financing or refinancing of income-yielding assets by packaging them into a tradable, liquid form through the issue of bonds or other securities. 1 Impact of Securitisation on Capital Markets and Other Markets The development of the securitisation market over the last decades has had a number of beneficial effects on capital markets. By introducing a new class of debt instruments, and allowing access to new participants corporates and others to the market it has deepened the capital markets. Also, securitisation allows Originators to dispose of assets in an efficient way, and to achieve a more beneficial financing profile and better funding terms. It also allows investors to invest in assets which they otherwise could not access, and has greatly contributed to the availability of highly-rated bonds to investors. Thus securitisation is a highly efficient tool for diversification of financing and risks for investors and Originators alike. Securitisation has also helped to develop and promote other markets. For instance, in the United States, the government has, through two government agencies, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), been able to promote home ownership by stimulating the mortgage market. Fannie Mae and Freddie Mac buy mortgages from lenders and fund their activities by securitising those mortgages. In the United Kingdom, the government has used securitisation techniques to fund its private finance initiative, a policy designed to privatise and outsource certain government functions such as building and operating prisons, hospitals and schools. Thus, for example, a number of hospitals in the UK have been built using funds raised in the capital markets by issuing asset-backed securities. 1 There are three principal types of securitisation: true sale, synthetic and "whole business" (the latter is primarily used in the United Kingdom and, to a lesser extent, continental Europe). In a true sale securitisation, a company sells assets to a special purpose vehicle (the SPV) which funds the purchase by issuing securities in the capital markets. In a synthetic securitisation, the company does not sell any assets, but transfers the risk of loss associated with certain of its assets to an SPV or a bank against payment by such company of a premium or fee to the SPV. "Whole business" securitisation is essentially a loan secured by the entire assets generated by the business of the relevant company. To grant the loan, the SPV uses the proceeds of securities issued in the capital markets whereby the company grants security over all or most of its assets in favour of the holders of securities. This Position Paper deals primarily with true sale securitisation. Part II contains brief outlines of synthetic securitisation and "whole business" securitisation. Any reference in Part I to "securitisation" refers to true sale securitisation unless stated otherwise. Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 5

14 PART I: GENERAL OVERVIEW Types of Assets that can be Securitised The securitisation market in the United States and Western Europe is dominated by a number of asset classes (receivables): residential mortgage receivables, commercial mortgage receivables, credit card receivables, auto loans, consumer loans, trade receivables and uncontracted future cash flows (such as toll receipts). However the type of assets that can be securitised continues to expand (some of the key innovators in the securitisation process in Western Europe are governments). In principle, any assets or entitlements providing future (predictable) cash flows can be securitised to the extent that they can be effectively transferred to an SPV through a true sale 2 (or to the extent that the Originator is considered to be bankruptcy remote ). These may, for instance, include tax revenues or utilities payments. Brief Description of the Classic True Sale Securitisation In a true sale securitisation, a company the Originator or Seller sells a pool of its assets (often, receivables generated in the ordinary course of business) to an SPV. In order to finance the purchase of the assets, the SPV issues securities in the capital markets. The securities are referred to as asset-backed securities because the purchased assets typically represent the principal source of cash 3 to service the securities. It is imperative that once the sale and transfer of the assets to the SPV has been effected, it cannot be challenged, voided or otherwise reversed on the insolvency of the Originator or otherwise. This concept is referred to as true sale. Whether a transaction constitutes a true sale under the applicable law (notably, whether it will be recognised as such by the competent court on the Originator's insolvency) must be established through a legal analysis of the transaction. The legal insulation of assets from the Originator through a true sale may help to achieve one of the main benefits of securitisation, access to cheaper funding. If the credit quality of the securitised assets is higher than the credit quality of the Originator as a whole, the true sale may allow the Originator to obtain funding at better terms than would be the case through an on-balance sheet loan or a corporate bond issue. Thus Originators with a relatively modest capital market rating can obtain funding through asset-backed securities which have a relatively high rating from a rating agency or agencies. 2 This means that in case of the Originator's bankruptcy, the assets transferred for securitisation will not be subject to recovery by the Originator's bankruptcy receiver during the bankruptcy proceedings. This concept is considered in further detail below. 3 Depending on the individual structure, further sources of cash may include credit enhancement, a liquidity facility or proceeds from hedge contracts. These are described in more detail in Part II. Often, the sale and transfer of the securitised assets will not be disclosed to certain third parties (such as, in the case of receivables, the relevant obligors (Obligors)). The Originator will often continue to service the assets (e.g., collect the receivables) on the same terms as before the securitisation, and transfer the relevant proceeds to the SPV. Also typically, in order to enhance the quality of the assets and obtain funding at better terms, the Originator will provide security, called credit enhancement. Credit enhancement may be provided in a number of different forms, some of which are described in Part II. True sale securitisations can be split into two types standalone and conduit transactions. These are described in Part II. 6 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

15 PART I: GENERAL OVERVIEW ROLE OF THE RATING AGENCIES Most asset-backed securities are rated by one or more international rating agencies to enhance their attractiveness to investors and provide a guideline for their pricing. The rating agencies will closely examine the legal structure of the transaction (notably, the true sale element), the quality of the securitised asset pool and the ability of the Originator to service the assets. Based on this analysis and the credit enhancement mechanisms being used (and on other supporting arrangements, if any), the rating of the securities will be determined. BENEFITS OF SECURITISATION FOR ITS PARTICIPANTS Originators including corporates, banks and public sector entities securitise their assets for a variety of different reasons. The following is a list of the most common reasons for securitisation: raise funding by selling the securitised assets to the SPV; limit credit exposure to assets. Typically, following securitisation the Originator's credit exposure will be nil, or limited to any credit enhancement it may provide. In the case of banks, this may allow them to obtain regulatory capital relief. At the same time, the Originator often retains the ability to extract future profits from the assets; improve balance sheet ratios. A true sale securitisation may move the assets off the Originator's balance sheet, and replace them by cash, thus contributing to an improvement of the relevant balance sheet ratios. For instance, to the extent that proceeds of the securitisation are used to repay existing liabilities, this may reduce the Originator's leverage; tap different funding sources. Securitisation allows the Originator to diversify its funding sources away from banks and tap the capital markets (almost) directly, without having to issue securities on its own. Originators who already have established direct access to the capital markets (e.g., companies who have already issued corporate bonds) sometimes enter into securitisations to demonstrate to the capital markets that securitisation is available to them as a source of funding and to access different types of investors; reduce funding costs. The weighted average cost of the securitisation may be lower than the cost of the Originator's current bank or other debt. Notably, this advantage often arises when the credit quality of the securitised assets is higher than the credit quality of the Originator's balance sheet as a whole; and match assets and liabilities (securitisation provides a more flexible method by which assets and liabilities can be matched). Investors in asset-backed securities can benefit in a number of ways, including the following: through asset-backed securities, they can invest in asset classes and tranches with varying degrees of risk at their choice and generate the associated returns. This offers investors the opportunity to optimise the structure of their portfolios and access markets which otherwise they could not invest in; asset-backed securities have historically often been less subject to price fluctuation as compared to corporate bonds; asset-backed securities are known to offer a higher return than comparably-rated government, bank and corporate bonds; and Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 7

16 PART I: GENERAL OVERVIEW asset-backed securities are usually not susceptible to event risk or the risk of a rating downgrade of a single borrower. It is worth noting that securitisation is generally not perceived as a tax-efficient structure. Typically, the parties seek to keep the effects of securitisation on the participants' tax position (including profits tax and value added tax) neutral. The Securitisation Market in Europe and the United States The securitisation market began in the 1970's in the United States with the securitisation of residential mortgages by the Government National Mortgage Association. During the 1980's the market continued to develop in the United States with the introduction of new asset classes in particular, auto loans and credit card receivables. It started to grow exponentially in the 1990's, expanding to virtually all types of assets which yield future cash flows. The market now represents one of the most prominent fixed income sectors in the United States, with annual new issues of approx. USD 450 billion. In Western Europe the securitisation market developed in the late 1980's and early 1990's. The initial key asset classes were residential mortgages and consumer loans. The market developed rapidly in the 1990's, particularly in the United Kingdom, France, Spain, the Netherlands, Belgium, Germany and Italy. New European issues in 2003 amounted to approx. EUR 160 billion. Lately, securitisation has also been increasingly used as a funding instrument by a number of European governments and other public authorities. Potential Benefits of Securitisation for Russian Capital Markets Securitisation could be a powerful tool to create new high-quality funding and investment opportunities in Russia's domestic capital markets. Russian companies and banks, and also government and other public sector entities, could gain access to relatively inexpensive funding. Institutional investors such as pension funds and insurance companies could invest their funds in, and earn returns from, low risk domestic assets. The wide use of securitisation could foster home ownership as well as add liquidity to the domestic credit markets. Generally, securitisation could help to deepen and greatly expand the Russian capital markets. Last but not least, the federal government, regional governments, and large municipalities, could use securitisation to obtain funding or finance specific projects. It should be noted that the recently enacted Russian Law on Mortgage-Backed Securities represents a very important first step in legislative attempts to introduce new legal concepts promoting domestic securitisations of mortgage loans in the Russian market. The Law envisages two types of mortgage-backed securities (mortgage participation certificates and mortgage-backed bonds) with a view to reflect the pass-through and paythrough concepts underlying most securitisations. However, the Law on Mortgage- Backed Securities was adopted in the absence of a general legislative framework for securitisations. Thus, most of the new legal concepts it contains (such as, inter alia, mortgage pool, mortgage agent, fiduciary management of mortgage pool) are not sufficient to launch domestic asset securitisations and, as such, require further elaboration and amendments to other laws. 8 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

17 PART I: GENERAL OVERVIEW Both the Russian state authorities and market participants are already seeking to improve the provisions of the Law on Mortgaged-Backed Securities. 4 On the understanding that comprehensive reform of Russian legislation is needed to overcome the key legal and regulatory obstacles for securitisation, it is highly desirable to ensure that the work on improvement of the Law on Mortgaged-Backed Securities and the introduction of general securitisation requirements to Russian legislation is coordinated and carried out simultaneously. Securitisation Laws Adopted by European Countries In recognition of the benefits of securitisation, and the need of market participants to use securitisation as a funding and investment instrument, a number of European countries have adopted a number of specific securitisation laws. These countries include France, Italy, Spain, Portugal, Greece, and Luxembourg. Further, Poland has begun to draft securitisation laws. The content of these laws differs as each has been specifically designed to overcome legal obstacles which had previously prevented the use of securitisation in the relevant jurisdiction. A summary of some of these laws is provided in Annex 1 to this Position Paper. 4 Federal Law No. 152-FZ "On Mortgage-Backed Securities" dated 11 November Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 9

18 PART II: TECHNICAL ASPECTS OF SECURITISATION PART II: Technical Aspects of Securitisation Parties and Their Roles The key parties involved in a securitisation and their roles 5 are as follows (further parties may be involved depending on the structure of the individual transaction): 5 Further details of their roles will be set out in Paragraph "Typical Securitisation Structures" below (see page 11). Originator owner and generator of the assets to be securitised. Originators may be banks and other financial institutions, corporates, government authorities and municipalities; Seller seller of the assets to be securitised. In many cases, the Seller and the Originator in a transaction are identical. This is however not necessarily the case. For instance, an entity may purchase assets from its affiliates and then act as the main Seller in a securitisation; Purchaser a special purpose vehicle (SPV) which purchases the assets to be securitised. The Purchaser funds the purchase price by issuing asset-backed securities in the capital markets (in this capacity, the Purchaser is also referred to as the Issuer); Servicer services the assets to be securitised (frequently the Originator retains this role). Where receivables are securitised, the Servicer will receive, manage and, if necessary, recover the receivables through legal proceedings; Back-up Servicer will service the assets if the Servicer is unable to do so, or where the Purchaser exercises its right to remove the Servicer (for instance, as a result of the insolvency of the Servicer); Liquidity Facility Provider provides a liquidity facility to the Issuer. Typically, a liquidity facility is provided in conduit transactions 6 where the Purchaser issues revolving short-term commercial paper to fund the purchase of the assets. The Purchaser may draw upon the liquidity facility if it is unable to refinance maturing commercial paper because of a market disruption. The liquidity facility thus secures commercial paper investors against a default in such a case. Liquidity facilities are also sometimes used in standalone securitisations; Investors purchasers of the asset-backed securities. Examples of investors in the securitisation market are: pension funds, banks, mutual funds, hedge funds, insurance companies, central banks, international financial institutions and corporates; 10 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

19 PART II: TECHNICAL ASPECTS OF SECURITISATION Lead Manager arranger and structurer of the transaction (in the context of conduit transactions, also referred to as Programme Administrator). The Lead Manager is often the primary distributor of the asset-backed securities in a particular transaction. Individual distributors are also referred to as Managers; Rating Agencies rate the asset-backed securities. The three key rating agencies in securitisation are Standard & Poor's, Moody's and Fitch; Hedge Providers hedge any currency or interest rate exposures the Issuer may have; Cash Administrator provides banking and cash administration services to the Issuer; Security Trustee acts as an asset manager for the secured creditors of the Issuer (notably, holds the Issuer's assets granted to it as security for the Issuer's obligations, on behalf of the Investors); Note Trustee acts on behalf of the holders of the asset-backed securities; Auditors if necessary they audit the asset pool as may be required under the documentation of the relevant transaction. Typical Securitisation Structures Classic Securitisation Through True Sale Description of the Structure The above diagram shows a typical structure for a true sale securitisation. The Originator (for instance a bank selling mortgages) sells certain assets (the Assets) to the Issuer. The Assets will be serviced by the Servicer (often the Originator). For instance with respect to mortgages sold to the Issuer, the Originator will continue, on behalf of the Issuer, to collect principal and interest from borrowers on such mortgages and will, where appropriate, take enforcement action in respect of such defaulted mortgages. As the Issuer has no employees it will appoint a Cash Administrator to make all relevant payments on its behalf and is also likely to appoint a company to provide company secretarial and other administrative functions. 6 See page 13. Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 11

20 PART II: TECHNICAL ASPECTS OF SECURITISATION The Issuer funds the purchase of the abovementioned assets by selling asset-backed securities (whose performance is dependent on the performance of the Assets) (the Bonds) to the Managers who will in turn sell those securities to the Investors. Investors will be free to sell the Bonds or retain them. Cash Flow Types of Securitisation Structures There are three most common types of securitisations from the standpoint of organising cash flow: Collateralized Debt, Pass-Through and Pay-Through structures. Collateralized debt is the form most similar to traditional borrowing secured by assets. The owner of assets borrows money and pledges assets to secure repayment. The assets pledged may be assessed according to their market value upon sale or their ability to generate a cash flow stream. The debt instrument need not match the cash flow configuration of any of the assets pledged. Pass-through securitisation is a way of securitising assets which generate a regular cash flow, by selling direct participation in the pool of assets. In other words, a passthrough certificate represents an ownership interest in the underlying assets and thus in the resulting cash flow. Principal and interest collected on the assets are passed through to the security holders; the seller acts primarily as a Servicer. In a pay-through securitisation, the assets are typically held by a limited purpose vehicle (the Issuer) that issues debt collateralized by the assets. Like in case of a pass-through, the debt service is met by cash flow paid through to investors out of the pledged collateral. Investors in a pay-through bond are not direct owners of the underlying assets; they have simply invested in a bond backed by certain assets. Therefore, the issuing entity can manipulate the cash flows into separate payment streams. Thus pay-through securities may be structured so that the cash flows generated by the assets can be reconfigured to support forms of debt unlike those of the underlying assets. Structure of the Issuer SPV Issuers are usually incorporated as insolvency remote entities. By virtue of its corporate constitution, the Issuer may not engage in any transactions other than those necessary to effect the securitisation ( limited legal capacity ). As a consequence this the SPV will not be allowed to issue any additional debt or to enter into mergers or similar transactions. All parties to contracts with the Issuer agree that they will not petition for the winding-up or insolvency of the Issuer, and the Issuer undertakes not to enter into voluntary liquidation. In addition, the parties will acknowledge that the extent of any demands they may have is limited to the available assets of the Issuer, and subject to the order of priority (the payment waterfall or agreed payment procedure ) agreed in the transaction documents. Where the Issuer is a company, it is often owned by a charitable trust, which ensures independent control of the Issuer. Often the Issuer's assets will be pledged to the respective note holders. Bonds: Listing and Investor Guidelines Bonds are often listed on a stock exchange (in Europe the Irish Stock Exchange and the Luxembourg Stock Exchange are two of the most popular). One of the principal reasons for listing Bonds is that Investors' internal investment rules require them to invest in listed securities. In addition, such rules may also require that the Bonds be rated (many 12 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

21 PART II: TECHNICAL ASPECTS OF SECURITISATION Investors require that Bonds are rated at least at investment grade or above) by a rating agency. The higher the rating a Bond achieves the wider the potential investor base and the lower the interest rate payable on such Bond a high rating indicates a high likelihood the Issuer will be able to pay interest and principal on the Bonds. Conduit vs. Standalone Transactions In conduit transactions, the Purchaser (also referred to as Conduit) usually purchases and securitises assets from a number of different Originators. The Purchaser refinances these purchases by issuing asset-backed commercial paper in the capital markets. Commercial papers are short-term fixed income securities, the interest on which is typically reflected by a discount on the issue price. At maturity, commercial papers are redeemed at par. Depending on the structure, the Purchaser may also borrow the necessary funds from another entity (the CP Issuer) which issues the commercial paper. To address the risk of a disruption in the commercial paper markets, the Purchaser (or CP Issuer) must obtain stand-by funding through liquidity facilities from highly rated banks. Conduits are usually organised by banks who arrange securitisations for their clients. Those banks might also provide additional support to the Conduit, in the form of a credit enhancement programme if required by the Rating Agencies. In a standalone transaction the Purchaser only purchases assets and issues assetbacked securities in the context of a single securitisation transaction. Typically, the Purchaser in a standalone transaction does not issue commercial paper, but securities with a term sufficiently long to cover the entire transaction. Investors are protected against the insolvency of the Purchaser through a security structure whereby the Purchaser pledges its entire assets to a Security Trustee, who holds the assets for the benefit of the Investors. Synthetic Securitisation The above diagram shows a typical structure for a synthetic securitisation. As you will note it is very similar to a true sale and most of the structural features are the same. The key difference is that the Originator does not sell any assets to the Issuer (and Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 13

22 PART II: TECHNICAL ASPECTS OF SECURITISATION therefore does not obtain any funding or liquidity under the transaction). Instead the Originator will enter into a credit default swap with the Issuer in respect of an asset or pool of assets. Under this contract the Issuer will pay the Originator an amount equal to any credit losses suffered in respect of such asset or pool of assets (less a minimum threshold amount similar to an excess in insurance). The Originator's exposure to those assets is therefore transferred to the Issuer. The Originator in return will pay a fixed amount to the Issuer, usually on a quarterly basis. The Issuer will issue Bonds to Investors via the Managers. The Issuer's ability to repay the principal and pay interest under the Bonds will depend on whether the Issuer has to make payments under the credit default swap. The Issuer's income streams in a synthetic transaction are the fixed amounts paid by the Originator under the credit default swap and interest amounts received on the collateral. In order to collateralise its obligations under the credit default swap and the Bonds the Issuer usually purchases securities as collateral. These are normally highly rated government debt securities. They also need to be relatively liquid in order that they can be sold and the proceeds used to pay amounts under the credit default swap or Bonds, as the case may be. Whole business Securitisation This type of securitisation originated in the United Kingdom. It involves the provision of a secured loan from an SPV to the relevant Originator. The SPV issues bonds in the capital markets and lends the proceeds to the Originator. The Originator services its obligations under the loan through the profits generated by its business. The Originator grants security over most of its assets in favour, ultimately, of the Investors. Whole business securitisation is sometimes used to finance a taking private or management buy out of the Originator. Typical Elements of a Structure The following describes structural features which are often used in transactions to improve the credit quality of the issued securities and better protect Investors' interests. A key feature is that payments made by the Issuer to holders of Bonds and other relevant parties are made in strict sequence in accordance with a priority of payments (also commonly called a payment waterfall or agreed payment procedure ). Thus certain parties will be paid out in full before others. The quality of the Bonds can be enhanced by issuing a number of tranches or classes of Bonds. For instance, if two tranches are issued Tranche A will be senior to Tranche B. Thus, payments on Tranche B will be subordinated to payments on Tranche A (payments are usually split between principal and interest with both types being subordinated) by way of the priority of payments. Therefore no payments can be made in respect of Tranche B until payments due on that date have been made in full in respect of Tranche A. Tranching of a bond issue is a form of credit enhancement (i.e. it enhances the credit of the more senior notes Tranche A in the example and enables them to attain a higher rating). Pursuant to the new Basel II Accord on capital adequacy, drafted by the Basel Committee on Banking Supervision, the issue by an SPV of at least two tranches of securities is a standard and even necessary element of the classic securitisation transaction. 14 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

23 PART II: TECHNICAL ASPECTS OF SECURITISATION If the Originator is not able to allocate inflows of cash from its debtors at the necessary speed, a pledge of the bank account at which proceeds from the Assets arrive, or the establishment of an escrow or blocked account structure could be used to mitigate the commingling risk. Other common forms of credit enhancement are cash deposits from Originators and reserve accounts, which may be formed of a deferred portion of the purchase price payable for the Assets. The Issuer will utilise the credit enhancement available when there is a payment default or other loss in respect of the Assets. The Issuer should also hedge any currency or interest rate risk that it may have, through hedging contracts with highly rated counterparties. If, for instance, the Assets provide an income which is fixed rate but some or all of the Bonds are floating rate the Issuer will enter into an interest rate swap which will hedge its interest rate exposure (an increase in floating rates would lead to the Issuer having to pay more under the Bonds while receiving the same income from the Assets). The Issuer will pay the Hedge Provider a fixed rate and will receive a floating rate. Similar hedging arrangements are necessary if the currency of the Assets differs from that of the Bonds. Typically the Hedge Provider is an investment bank (often the Lead Manager). The Hedge Provider will sometimes enter into what is called a back-to-back hedge with the Originator which will pass on the relevant risk onto the Originator. Frequently a liquidity facility is used. A liquidity facility is a stand-by bank facility which may be drawn in the event that the Issuer is unable to repay maturing debt. Commonly, the liquidity facility may be drawn in case of a market disruption (if the securities are issued in the form of revolving commercial paper), but also if the quality of the Assets has decreased in such a way as to no longer allow for funding of purchases of additional assets through issuance of highly rated asset-backed securities, or if cash flow shortages occur. Generally however, the liquidity facility may not be used to refinance defaulted Assets and thus, is not a Bond credit enhancement. In standalone securitisations 7 the Issuer will typically grant security to a Security Trustee over the Assets and all its rights under the contracts it enters into in favour of the holders of the Bonds (the Investors) and if applicable other parties to the transaction. The Security Trustee will act on behalf of these secured creditors. In order to facilitate communication with the holders of the Bonds a Note Trustee is appointed which acts on behalf of Investors. Role of the Rating Agencies Rating Agencies provide, in the context of the securitisation market, a credit rating of the asset-backed securities issued by the Issuer. A credit rating is (usually) an opinion on the likelihood that the Issuer will be able to pay full principal and interest on the rated security in a timely manner in accordance with the terms of the security. Rating Agencies normally consider the type and quality of assets to be securitised; the structure of the transaction and how it proposes to provide Investors with payments of interest and principal; the risks in the transaction (including market, counterparty, sovereign and legal risks); the flow of funds including coverage of all the expenses of the transactions; and debt service coverage whether internal or from a third party credit and/or liquidity provider. The entire analysis is, typically, effected on the basis of criteria published by the respective Rating Agency. 6 Cf. Paragraph 2.2 above for an explanation of the term "standalone transaction". Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 15

24 PART II: TECHNICAL ASPECTS OF SECURITISATION Rating Agencies play an integral role in securitisations (at least those that are rated) and have a considerable degree of input with respect to how cash flows and the legal framework are structured in a securitisation. Impact of a New Accord of the Basel Committee on Banking Supervision Regarding Capital Adequacy (Basel II) Basel II is the name of the consultation document which amends the current bank standards for capital adequacy (the Basel Capital Accord originally signed in 1988). Basel II establishes the overall methodological approaches to calculating capital adequacy, the principles for implementing the special procedures for monitoring capital adequacy by the bank supervisory authorities, and also the demands for banks to disclose information on capital and risk in order to strengthen market discipline. Both the Basel I Accord and the new Accord determine that the minimum amount of owned equity (capital) for credit institutions is to be based on the principle of recording the quality of bank assets and the associated risks. In comparison with the current Accord, Basel II sets out new, more flexible approaches for the assessment of risk under a given asset type. These principles provide (i) the possibility of using external ratings published by specialised rating agencies, and also (ii) the possibility for banks to use their own methods of internal asset risk assessment, or internal ratings. Basel II is currently scheduled for implementation in early The Russian Central Bank proposes to implement Basel II in Basel II has a special Paragraph on securitisation which will influence the procedure for completing securitisation transactions. (Chapter IV Credit Risks Securitisation Framework). Basel II will determine to what extent, and under what conditions a bank may obtain regulatory capital relief if it securitises its assets, as well as how much regulatory capital, calculated in accordance with banking law, must be allocated by a bank purchasing asset-backed securities. Basel II will also contain rules on how much regulatory capital, calculated in accordance with applicable law, should be provided for the provision of liquidity enhancement facilities. Basel II defines a classic securitisation transaction as a tranche structure. The risk assessment method for banks participating in securitisation transactions in order to determine their capital adequacy is based on risk assessment of the participants' positions caused by a particular class of security. Whether Basel II will have a direct impact on domestic Investors and Originators in the Russian Federation will depend on what variants for implementation of the Accord are selected by the Russian Central Bank in its capacity as the national body for bank supervision. However that turns out, Basel II will affect the ability of Investors which are subject to Basel II to invest in Russian asset-backed securities. 16 Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs

25 PART II: TECHNICAL ASPECTS OF SECURITISATION Accounting Rules Depending on the accounting rules applying in the individual case, true-sale securitisation will in many cases have an impact on the financial statements of the transaction participants, notably the Originator. For instance, the sale of assets might result in those assets being removed from the Originator's balance sheet. At the same time, the Originator would record an increase of its cash position, reflecting receipt by it of the purchase price. Also, in certain cases the Originator might have to consolidate the SPV. The effects of securitisation on the Originator's financial statements will vary depending on the jurisdiction and the accounting rules which have to be applied. The following gives a brief overview of the treatment of securitisation under IAS 8, because in a large number of jurisdictions consolidated financial statements of large corporations are prepared in accordance with IAS. One of the standards which is particularly applicable to securitisation under IAS ( IAS 39 ) has changed only recently, in December 2003, and therefore, the description given below is subject to further review based on the experience of applying the new rules. For consolidated financial statements, the first step is to consolidate any SPV in accordance with SIC 12. In essence, the SPV will have to be consolidated if any of the following are true: its activities are conducted on behalf of the Originator; decision making powers with respect to the SPV have been retained by the Originator or delegated via an auto-pilot mechanism; and the majority of any economic benefits which will be distributed by the SPV, have been retained by the Originator; and/or if the majority of the residual or ownership risks have been retained by the Originator. The next step is to determine whether an asset has been actually transferred to a third party. The assumption of a contractual obligation to pay the cash flows to a third party, for example through the issue of securities by an SPV, can in some circumstances qualify as an asset transfer, subject to certain conditions. The next step is to consider whether the group has retained substantially all the risks and rewards. If it has, the assets remain on its balance sheet. If not, then one considers whether control has been retained. If the group has not retained control it derecognises the asset and recognises any new rights or obligations arising, i.e. 'components approach'. If the group retains control it continues to recognise the asset to the extent of its continuing involvement. Securitisations in particular will be affected by the new rules, and existing structures may fail to qualify as a result of the transfer of the risks and rewards test. Consequently securitised assets will remain on an Originator's consolidated balance sheet. If, however, they do pass the risks and reward and control tests, the continuing involvement provisions will require a complex calculation to determine the amounts to be retained on the balance sheet and the extent of any gain or loss on sale. 8 See page 13 above for an explanation of the term "Standalone Transaction". Securitization in Russia Ways to Expand Markets and Reduce Borrowing Costs 17